Emergency Fleet Corporation building. Washington, DC
Ilargi: As job loss numbers keep on rising (even according to the Bureau for Lamentable Statistics), home prices are in mid-plunge freefall and loans of all sorts and shapes see sharply rising default rates, hundreds of billions of dollars are in the process of being milked out of the public purse. I'm more convinced by the day that the biggest AIG scandals are yet to come.
Not only has the company, "good" for the largest US government bail-out by far, been used to transfer billions in hidden funds to Wall Street CDS counterparties, those same partiea are now invited to use the one-time insurer as a kind of "middleman window" through which they can buy each other's toxic assets for 5 cents on the buck, an exercise in legal crime in which the public figures as the anonymous and silenced bagholder. Have Geithner and Summers written yet another plan with unfortunate loopholes, or have they yet again set up their friends and donors for more of the same windfall? You be the judge.
How much longer will we believe in honest mistakes? How much more of it will we accept, coming from the same cabal time after time? Are we going to wait till there's nothing left to lose? It's all, and all the time, to absurd to believe. One thing is certain: this will not stop until we make sure that there is a very solid barrier between Wall Street and Washington, and until the present crew has been banned from the US Treasury.
NOTE: This is the only post for today, I'm about to switch computers, and file tranfers by the experts here in MTL will take up most of the afternoon. I'll do one post each on Saturday and Sunday as well.
The West's Fatal Overdose
The G-20 has agreed on plans to fight the global downturn. But its approach will only lay the foundation for the next, bigger crisis. Instead of "stability, growth, jobs," the summit's real slogan should have been "debt, unemployment, inflation." Now they're celebrating again. An "historic compromise" had been reached, German Chancellor Angela Merkel said at the conclusion of the G-20 summit in London, while US President Barack Obama spoke of a "turning point" in the fight against the global downturn. Behind the two leaders, the summit's motto could clearly be seen: "stability, growth, jobs." When the celebrations have died down, it will be easier to look at what actually happened in London with a cool eye. The summit participants took the easy way out.
Their decision to pump a further $5 trillion (€3.72 trillion) into the collapsing world economy within the foreseeable future, could indeed prove to be a historical turning point -- but a turning point downwards. In combating this crisis, the international community is in fact laying the foundation for the next crisis, which will be larger. It would probably have been more honest if the summit participants had written "debt, unemployment, inflation" on the wall. The crucial questions went unanswered because they weren't even asked. Why are we in the current situation anyway? Who or what has got us into this mess?The search for an answer would have revealed that the failure of the markets was preceded by a failure on the part of the state. Wall Street and the banks -- the greedy players of the financial industry -- played an important, but not decisive, role.
The bank manager was the dealer that distributed the hot, speculation-based money throughout the nation. But the poppy farmer sits in the White House. And during his time in office, US President George W. Bush enormously expanded the acreage under cultivation. The chief crop on his farm was the cheap dollar, which eventually flooded the entire world, artificially bloating the banks' balance sheets, creating sham growth and causing a speculative bubble in the US real estate market. The lack of transparency in the financial markets ensured that the poison could spread all around the world. There are -- even in the modern world -- two things that no private company can do on its own: wage war and print money. Both of those things, however, formed Bush's response to the terrorist attacks of Sept. 11, 2001. Many column inches have already been devoted to Bush's first mistake, the invasion of Baghdad. But his second error -- flooding the global economy with trillions of dollars of cheap money -- has barely been acknowledged.
No other president has ever printed money and expanded the money supply with such abandon as Bush. This new money -- and therein lies its danger -- was not backed by real value in the form of goods or services. The measure may have had the desired effect -- the world economy revived, at least initially. And US consumption kept the global economy going for years. But the growth rates generated in the process were illusionary. The US had begun to hallucinate. The addiction to new cash injections was chronic. The US had allowed itself to sink into an abject lifestyle. It sold more and more billions in new government bonds in order to preserve the appearance of a prosperous nation. To make matters worse, private households copied the example of the state. The average American now lives from hand to mouth and has 15 credit cards. The savings rate is almost zero. At the end of the Bush era, 75 percent of global savings were flowing into the US.
The president and the head of the Federal Reserve, Alan Greenspan, knew about the problem very well. Perhaps the Americans even knew just how irresponsible their actions were -- at any rate, they did everything they could to hide them from the world. Since 2006, figures for the money supply -- in other words, the total number of dollars in circulation -- have no longer been published in the US. As a result, a statistic which is regarded by the European Central Bank as a key indicator is now treated as a state secret in the US. Only on the basis of independent estimates can the outside world get a sense of the internal erosion of what was once the strongest currency in the world. These estimates report a steep rise in the amount of money in circulation. Since the decision to keep the figures confidential, the growth rate for the expansion of the money supply has tripled. Last year alone, the money supply increased by 17 percent. As a comparison, the money in circulation in Europe grew by a mere 5 percent during the same period. But the change of government in Washington has not brought a return to self-restraint and solidity. On the contrary, it has led to further abandon.
Barack Obama has continued the course towards greater and greater state debt -- and increased the pace. One-third of his budget is no longer covered by revenues. The only things which are currently running at full production in the US are the printing presses at the Treasury. At the summit in London, delegates talked about everything -- except this issue. As a result, no attention was given to the fact that the crisis is being fought with the same instrument that caused it in the first place. The acreage for cheap dollars will now be extended once again. Only this time, the state is also acting as the dealer, so that it can personally take care of how the trillions are distributed. The International Money Fund was authorized to double, and later triple, its assistance funds -- by borrowing more. The World Bank is also being authorized to increase its borrowing. All the participating countries want to help their economies through state guarantees, which, should they be made use of, would result in a huge increase in the national debt. The US is preparing a new, debt-financed economic stimulus package. Other countries will probably follow its example. We live in truly historic times -- in that respect, German Chancellor Angela Merkel is right. The West may very well be giving itself a fatal overdose.
What the French revolution can teach America
“Eat the wealthy.” The ferocity of the words used by some demonstrators in London on the eve of the Group of 20 summit evokes the worst excesses of the French revolution. Anti-capitalist anger in the west is not confined to Europe. Alexis de Tocqueville’s The Ancien Régime and the Revolution is as relevant to understanding today’s America as his deep and eye-opening thoughts on the young American republic in his Democracy in America. Of course, America in 2009 is not France in 1788, the year before the fall of the Bastille (the prison that embodied the oppressive nature of the monarchical regime) and the symbolic beginning of the French revolution. The fall of Lehman Brothers in September 2008 has nothing to do with the fall of the Bastille; symbols of wealth should not be confused with symbols of oppression. There is no guillotine around the corner and it would take a lot of imagination to compare President Barack Obama to Louis XVI, or Michelle Obama to Marie-Antoinette.
Yet as a European living in America – watching news on television every night, talking to friends, colleagues or my students – I sense fear, anger and a deep feeling of injustice reminiscent of the climate on the eve of the French revolution. Just replace bread shortages with foreclosures, aristocrats with bankers, and privileges such as the right not to pay tax with stock options. Add to that support for the king but rejection of many of his ministers, and the comparison looks less far-fetched. The explosion of populist rage that has accompanied the AIG scandal, amplified by an opportunistic Congress and by media that play to the tune of their audiences when not reinforcing their passions, reflects the depth of suffering in the US. Main Street, like much of France at the end of the 18th century, is outraged. Fear for its own present and future is combined with anger at those it considers responsible, and who are much less affected than they. Are not senior bankers today like the aristocrats of yesterday, their privileges no longer justified by their social functions – to serve the king with their swords or to contribute to the creation and dissemination of wealth?
The problem with the economic team of the new president is that, like the court of the king of France in pre-revolutionary times, it has inherited all the bad reflexes of the ancien régime, mixing excessive sympathy for the outdated logic of the world of finance, which it helped to create, with insensitivity to the emotions of the ordinary people, which it tends to ignore. This sympathy is perceived to contrast with the harsh treatment of carmakers. Bankers and financiers have to reinvent not only their trade but also their way of life and, above all, their value system. In the Madoff scandal, just as shocking as the crime of an individual was the behaviour of many of his rich customers, who combined greed with a lack of financial common sense. An interesting incident was reported by CNN last week. A group of protesters – very few, to be honest – rented a bus in Connecticut and stopped in front of the mansions of AIG executives to express support for those who had returned their bonuses and outrage against those who had not and were still living in grand style, in contrast with the many more who had lost nearly everything.
The greed of some was tolerated as long as most of society continued to progress. But today’s combination of fear and humiliation with a deep sense of injustice leads to anger that is potentially irrepressible. The strength of the American republic has been bolstered by the popularity of its new president. This capital should not be squandered on reliance on a media-savvy communication culture. As can be seen so often in history, less is more. The president of the US simply speaks too much. Revolution is not around the corner; at least, not in America. But there are lessons Mr Obama can learn from the French king’s failure to manage dissent. He must not fall prey to populism. His goal is to save the economy, not punish the bankers. At the same time, he must not be seen to have too much sympathy for the world of finance and its excesses or to cut himself off from the suffering of his people. If he fails, the corporate laws of today will face the same fate as the ancien régime rights of yesterday. World leaders’ agreements, substantive or superficial, will not suffice. It is the trust of their respective citizens, translated into hope and confidence, that will make the difference.
Taming Populist Anger Is Big Test
Populist anger is like a long-caged animal now on the loose, and the success of President Barack Obama's economic policy may well depend on whether he can tame it and put it to good use in the next few months. The crucial test likely will come late in the year, if the president has to return to Congress to get another -- perhaps final -- dose of money to complete the rescue of the financial sector. Right now, the surge in populist sentiment means there is virtually no political support for such a move; the key question is whether passions can be cooled by the fall. To fully appreciate this challenge, consider a little-noted but significant turn of events in Congress this week.
In the budget it submitted for the next fiscal year, the Obama administration tried to quietly pave the way for another dose of financial-bailout money by including a placeholder request for $250 billion in rescue funds, to start financing the ultimate purchase of perhaps an additional $750 billion in toxic bank assets. But now the House and Senate are finishing up budget bills that have simply sliced out that money. If the administration needs more rescue funds later this year -- and most analysts think that's likely -- it will be starting from scratch. That won't be easy, because the populism now standing in the way has some deep roots. It's tempting to think it all started with those big bonuses for executives from firms being bailed out with billions of dollars in taxpayer money. Tempting -- but incorrect.
Bonuses may have sent the pitchfork brigades into the streets, but the social forces behind the surge have been years in the making. The primary cause is a broad feeling, now upheld by a large body of academic work, that the distribution of income has become skewed in recent years. Put simply, those at the top of the income ladder have done noticeably better in the past two decades than have those in the middle or bottom. Frank Levy of the Massachusetts Institute of Technology, a leading scholar of income trends, has noted that median family income, in constant 2005 dollars, rose from about $22,000 to $50,000 during the period from the end of World War II through 1980. Since then, except for a bump up in the latter 1990s, median family income has been relatively flat. In fact, Census Bureau statistics show it actually fell from 2000 to 2007.
In the top 1% of American households, meanwhile, median income increased by about $250,000 between 1986 and 2005. But that tells only part of the story. A disproportionate share of this increase at the top has come from the financial sector -- the very sector that has been dragging down the entire economy. Income growth for those in the financial sector tracked other industries through the early 1980s but then began moving well ahead of other businesses. "When we say that the top 1% of tax filers now receive something over 17% of all taxable income, it will not surprise you that a significant fraction of that top 1% comes from the financial sector," Mr. Levy noted in a late-2007 speech, just before the storm hit the financial world. As the financial sector was soaring, the manufacturing base -- traditional source of so many of those earlier gains in the middle incomes -- was undergoing a broad contraction.
The recent numbers are dramatic. In this decade alone, the U.S. has lost 4.8 million manufacturing jobs. While unemployment nationally hovers around 8%, in the manufacturing sector it stands at 11.5%, and has more than doubled in a year's time. Meanwhile, some of the social sinews that once linked those at the top and those in the middle of the income scales also have come undone. Military service, once a great social equalizer bringing together upper and lower classes, is increasingly a middle- and lower-class enterprise. As public schools in cities have declined, a growing share of upper-income Americans have opted for private education.
The cumulative result is a more stratified society. Mr. Obama's strategy for dealing with the resulting anger has been to call it understandable -- and then, having accepted it as legitimate, try to damp it down. That's why you saw the president, on the day the House passed a bill to slap a 90% tax on bonuses paid to executives of American International Group and others, issue a statement saying the vote "rightly reflects the outrage that so many feel" -- but then almost immediately dial back the rhetoric to say "we're all in this together." It's also why the White House has been quiet as the drive to pass any similar bonus-bashing bill in the Senate has slowed to a crawl.
In the long run, the administration is trying to tell the pitchfork brigades that it intends to use the power of government to try to reduce income gaps -- raising taxes on the wealthy, cutting those on the middle class, giving refundable tax credits to the working poor. When Treasury Secretary Timothy Geithner was asked about income inequality on ABC's "This Week" last weekend, he said explicitly: "It should go down." The goal, he said, is a recovery in which "the gains are more broadly shared across the economy as a whole."
US payrolls fall 663,000 in March while unemployment rate jumps to 8.5%
5.1 million jobs lost in this recession so far
American workers were hammered again in March with large job losses, pushing the total number of jobs lost since the recession began to 5.1 million, the Labor Department reported Friday. U.S. nonfarm payrolls fell by 663,000 in March, close to expectations, while the unemployment rate jumped to a 26-year high 8.5% from 8.1%, as expected. "This recession is far from over," wrote David Rosenberg and Sheryl King, economists for Bank of America's Merrill Lynch. "There is nothing in this report that points to economic recovery," said economists at RDQ Economics. Details of the report confirm that the U.S. economy likely contracted violently again in the first quarter. Economists believe gross domestic product likely fell at a 5.5% annual pace after a 6.3% decline in the last three months of 2008.
However, the dismal employment report also comes just as some "green shoots" of incipient growth have surfaced in more forward-looking economic indicators, such as consumer spending, building permits, factory orders, stock prices and consumer expectations. The labor market hasn't yet shown any signs of improvement. Leading employment indicators -- such as jobless claims or the number of temporary workers -- have worsened in recent months. Typically, payrolls are considered a coincident indicator of the economy, while the unemployment rate is a lagging indicator, turning up after everything else improves. "It appears that the jobless rate will continue to rise at a rapid clip over the next few months and should breach 10% sometime in the second half of 2009," wrote David Greenlaw and Ted Wieseman, economists at Morgan Stanley.
Details of the report were almost universally grim. Payrolls in previous months were revised lower by a total of 86,000. January's revised job loss of 741,000 was the worst since 1949. In February, 651,000 jobs were lost. In the past six months, 3.7 million jobs have been destroyed, or 2.7% of payrolls, the second-largest percentage loss in 50 years. Total hours worked in the economy fell by 1%. The average workweek fell by 6 minutes to a record-low 33.2 hours. "Businesses are girding for a long siege -- slashing employment and dividends," wrote Peter Morici, a business professor at the University of Maryland. "They are preparing for a depression and the eclipse of American leadership."
Job losses were widespread across industries in March. Among major sectors, only health care added jobs, but the increase of 14,000 was about half the average gain over the past six months. According to a survey of hundreds of thousands of work sites, goods-producing industries shed 305,000 jobs, and the services industries cut 358,000. Of 271 industries, just 22% were hiring in March. Manufacturing industries cut 126,000 workers. Hours worked in manufacturing fell by 2.1%. Construction cut 161,000 jobs. The unemployment rate for construction workers rose to 22.3%. In the services, professional and business services cut 133,000 jobs, including 72,000 temp jobs. Retail companies cut 48,000 jobs. Financial services cut 43,000 jobs. Transportation industries lost 34,000.
The separate survey of households showed employment dropped by 861,000, with unemployment rising by 694,000 to 13.2 million. The employment-population ratio dropped to 59.9%, the lowest rate since 1985. A separate gauge of unemployment that includes discouraged workers and workers who can find only part-time work rose to a record 15.6%, with data reached back to 1994. The number of workers who want full-time work but can only find part-time jobs rose by 423,000 to 9 million in March. Since the recession began, involuntary part-time workers have increased by 4.4 million. About a quarter of the 13.2 million officially unemployed have been out of work longer than six months, the highest percentage since 1983.
Prime Loan Default Rates Doubled as Credit Tightened
Delinquency rates on the least risky home loans, which account for two-thirds of all mortgages, more than doubled last year, showing credit quality deterioration is spreading through the housing market, U.S. regulators said. Seriously delinquent prime loans climbed to 2.4 percent of total loans on Dec. 31, from 1.11 percent in the first quarter, the Office of the Comptroller of the Currency and Office of Thrift Supervision said today in a report. Mortgages in delinquency rose 30 percent in the fourth quarter, accounting for 4.6 percent of all home loans, the report showed. “We’re in uncharted territory, we’ve never seen the number this high before,” John Dugan, U.S. Comptroller of the Currency, said in a Bloomberg Television interview today.
Prime loans account for most of the 35 million U.S. mortgages, and 553,736 were seriously delinquent, or 60 days or more overdue, in the fourth quarter, the report showed. Credit quality declined for a third consecutive quarter, as mortgages that are current fell below 90 percent as of Dec. 31 from about 93 percent on March 31 last year. The report also showed that mortgages modified in the first quarter, to help borrowers keep their homes, fell delinquent 41 percent of the time after eight months, and second-quarter modified loans had a 46 percent default rate, the report said. Third-quarter trends “are worsening,” the agencies said. “For the year and this quarter, we saw the same trend that we saw last time: quite high re-default rates, no matter how we measured them,” Dugan said in a conference call with reporters.
He said higher re-default rates are likely related to stressful economic conditions and new loan plans are not producing sufficient reductions to make mortgages sustainable. “Credit quality continues to decline and that’s true of all types of mortgages that we cover by risk category,” Dugan said. Lenders including Citigroup Inc. and loan-servicing companies are adjusting mortgages by lowering interest rates or crafting longer-term payment plans. The Obama administration is acting to help as many as 9 million struggling homeowners by using taxpayer funds to pay lenders such as bond investors and mortgage servicers for reworking the mortgages.
Borrowers with mortgages that were modified in the first quarter re-defaulted after three months 22 percent of the time, while loans revised in the second quarter had a 27 percent failure rate and third-quarter loans that were 60 days overdue failed 31 percent of the time, the report showed. The percentage of borrowers skipping the first payment on a modified loan rose significantly in all categories, except prime loans, the agencies said. Fourth-quarter first-payment defaults on subprime mortgages rose to 4.4 percent from 3.8 percent in the first, and overall climbed to 1.4 percent from 1.2 percent in the first, the report showed.
Bailed-out banks may buy toxic assets
U.S. banks that have received government aid, including Citigroup Inc, Goldman Sachs, Morgan Stanley and JPMorgan Chase & Co, are considering buying toxic assets to be sold by rivals under the Treasury's $1,000 billion plan to revive the financial system, the Financial Times said. Citigroup was considering whether to take part in the plan as a seller, buyer or manager of the assets, but no decision had yet been taken, the paper said, citing people close to the company. Goldman and Morgan Stanley have pledged to increase investments in distressed assets, the paper said.
This week, John Mack, Morgan Stanley's chief executive, told staff the bank was considering how to become "one of the firms that can buy these assets and package them where your clients will have access to them," according to the paper. Spencer Bachus, the top Republican on the House financial services committee, told the paper that he would introduce legislation to stop financial institutions "gaming the system to reap taxpayer-subsidized windfalls." Bachus added it would mark "a new level of absurdity" if financial institutions were "colluding to swap assets at inflated prices using taxpayers' dollars," according to the paper.
Have AIG's Trading Partners Profited from Its Distress?
Former AIG chief executive Maurice (Hank) Greenberg told Congress on Thursday morning that as much as $50 billion in payments that AIG has made in the past few months to banks and other financial firms, including Goldman Sachs and Deutsche Bank, should not have been made. Greenberg believes the banks should be forced to reinvest some of those trading profits in AIG by buying the company's shares. "The cash payments to CDS [credit-default swap] counterparties should never have occurred," Greenberg told a House oversight committee. Greenberg is not alone is raising questions about profits that financial firms have been making on the unwinding of AIG's derivative bets. Last week New York attorney general Andrew Cuomo said he was looking into AIG's trading records to examine whether the payments the company made to other financial firms were improper.
Also troubling: Wall Street veterans are complaining that banks and other investment firms — many of which are recipients of federal aid — may be taking advantage of the taxpayer bailout of AIG to boost their profits. "It seems very possible that the banks are forcing AIG to unwind its contracts at a premium," says James Bianco, who runs a financial-markets research firm in Chicago. AIG is in the process of unwinding its large derivative-trading book; in the past few months, it has terminated as much as $1.1 billion in derivative contracts. Traders say Goldman Sachs, Citigroup and others have either driven hard bargains with AIG or made specific trades that would benefit from AIG's problems. Those moves are exacerbating the losses at AIG and increasing the cost of the insurer's bailout. "There is an argument to be made that the recent profits at the banks are because of AIG," says Bianco.
Last month AIG said it had paid out about $50 billion to various financial firms to which it had sold credit-default swaps, which are insurance contracts sold to bond investors and others. When a bond defaults, a holder of a CDS has the right to be reimbursed for the loss by the seller of the contract. AIG was one of the largest sellers of such contracts. Much of the credit insurance AIG sold was on mortgage bonds, which are backed by home loans. As more and more homeowners defaulted, many of those bonds plummeted in value, causing the holders of AIG's CDS contracts to request payment. AIG used money it had received from the government to pay off those contracts. Now Greenberg and others argue that AIG should not have made good on many of those contracts.
These critics say it should have been obvious to the sophisticated financial firms who bought that insurance that AIG had no ability to pay out on such claims. So when AIG ran out of money, buyers of its insurance should have been forced to settle those claims for a fraction of what they were due. Instead, AIG took money from the government and paid the claims in full. "The plan to [liquidate AIG] has also been highly controversial and in some cases puzzling," Greenberg told Congress. "It would have been more beneficial for the American taxpayer if the Federal Government had ... provided guarantees to [AIG's] counterparties rather than putting up billions of dollars in cash collateral to those counterparties."
It is unclear how the payments AIG made to other financial firms could be clawed back. Unlike stocks, CDS contracts don't trade on an exchange. And trading partners can unwind those contracts at any prices they like. What's more, a rule change in late February, to which AIG voluntarily agreed, gives the insurer's trading partners more leeway to name their terms in the cases of bond defaults that trigger CDS payments. "Wall Street firms make money when people are in pain," says Frank Partnoy, who once traded credit-derivative contracts at Morgan Stanley and is now a law professor at the University of San Diego. "I don't know if that is what is happening, but if the question is whether banks would converge on a dying body — the answer is, Absolutely."
Why Geithner’s plan is the taxpayers’ curse
People who outbid others in auctions sometimes pay too much, a phenomenon known as the winner’s curse. Yet the plan outlined last week by Tim Geithner, US Treasury secretary, for pricing the toxic assets clogging up the financial system provides private investors with an unusually strong incentive to overpay: the government is proposing to pick up most of the tab if the assets turn out to be worth much less than was spent on them. Indeed, the more aggressively investors compete in bidding for these assets, the worse off the taxpayers will be. I call this the taxpayers’ curse. A simple example will illustrate the problem.
Suppose that a given bundle of mortgage-backed securities would be worth $20m (€15m, £14m) if you could be sure that all the mortgages will be repaid in full, but they might also turn out to be worthless. No matter how much you pay for them, the US government agrees to absorb any losses beyond approximately 15 per cent, while you get to keep half of any gains. In return, you only have to put up about 7.5 per cent of the purchase price. How much will the assets sell for? That depends on two things: how aggressively others bid and how much uncertainty there is about their ultimate value. For simplicity, assume the assets could be worth $20m or zero with equal probability. Assume that yours is the winning bid at a price of $10m. Under Mr Geithner’s plan, you put up $750,000 for an equity stake and the government puts up the remaining $9,250,000: a loan for $8,500,000 and $750,000 for an equal share of the equity.
There is a 50 per cent chance that you will get your money back in full and make a profit of $5m (in which case the other $5m in profit goes to the Treasury). Of course, it is equally likely that the assets will turn out to be worthless, but in that case all you lose is your initial payment of $750,000, and the Feds are on the hook for the rest. That works out to an expected profit of $2,125,000 for an investment of $750,000, a return of 283 per cent. If this seems too good to be true, it is: competition from other bidders will probably drive the bid price much higher. This would be unfortunate, however, because $10m is already the expected value of the asset. For example, a bid price of $14m would still be a bargain, because the investor’s expected profit would be approximately $1m on an initial investment of approximately $1m, which represents a 100 per cent return. Meanwhile, the taxpayers can expect to lose nearly 40 per cent of their money.
This is the singularly perverse feature of the Treasury proposal: the greater the competition among the bidders, the worse off the taxpayers and the more distorted the so-called “market” prices that result. More generally, one can work out the amount of price distortion and the expected returns to the taxpayers as a function of the variance in the realised values of the asset and the expected returns demanded by investors. For example, if there are two equally probable outcomes, one 50 per cent above the mean and the other 50 per cent below the mean, taxpayers can expect to lose money unless private investors make more than 180 per cent in expectation.
Some might argue that this is the price we must pay to get the financial system back on its feet but, in my view, it is much too steep. The problem is not merely the size of the bill, which could run into the hundreds of billions of dollars. The real difficulty is that the scheme perpetuates the very practices that got us into this jam in the first place. Over the last several decades, Wall Street wizards have developed products that most people cannot understand, including quite a few players in the financial markets themselves. The result has been mispricing and excessive risk-taking throughout the financial system. It is truly dismaying that the Obama administration, which publicly champions greater transparency, should put forward a proposal whose main object is to subsidise the banks without appearing to do so. Instead of making the prices of toxic assets more transparent, it is likely to inject a new level of price distortion and uncertainty into the markets, while putting taxpayers at great risk.
It may also allow banks to claim that assets remaining on their books after the auction should be priced at the same inflated level as the assets sold off. A more straightforward plan would be strongly to encourage banks to auction off tranches of toxic assets without providing subsidies to the purchasers. This would involve fewer gimmicks and produce prices that more nearly reflect the assets’ true economic value. If these auctions do not generate enough activity to clean up the banks’ balance sheets, the government will have to seize control of insolvent institutions temporarily and sell off their bad assets over a period of time, as happened in the wake of the S&L debacle of the 1980s.
How the FASB aids and abets obfuscation by wonky zombie banks
by Willem Buiter
The Financial Accounting Standards Board (FASB), at its meeting on April 2, has once again relaxed mark-to-market accounting rules. This occurred after the House Financial Services Committee, a wholly owned subsidiary of the American Bankers Association, had, at hearings on March 12, 2009, effectively ordered the FASB to revise its guidance on fair value in inactive markets. The HFSC used the threat that, if the FASB were not sufficiently accommodating, Congress would legislate on the matter off its own bat to give the zombie banks what they wanted. The FASB blinked and wimped under, as it had before. It made proposals less than a week after the House Financial Services Committee hearings. With some minor revisions, these proposals have now hardened into final guidance, despite protests from investor advocates and accounting-industry representatives, who argue that rigorously enforced mark-to-market rules force firms to reveal their least inaccurate picture of their true financial health. At the April 2 meeting, the FASB also voted to allow more flexibility in valuing so-called impaired securities, although this new flexibility is restricted only to debt securities.
Under FAS 157, the FASB’s standard on fair-value measurements, holders of financial assets recorded at fair-value must state what these values are based on. Three levels of information or assumptions are distinguished, corresponding to how “publicly observable” the information is. In level 1, the value of an asset or liability stems from a quoted price in an active market. In level 2, it is based on “observable market data” other than a quoted market price. In level 3, which often applies to asset valuations in illiquid markets or in “distressed” sales (or “fire sales”), fair value can be determined only by inputs that cannot be observed or verified objectively. Typically this means prices based on internal models or management guesses. Basically, the new guidance allows banks to shift a whole load of toxic and impaired securities from level 2 to level 3. Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’ asset sales when these transactions aren’t “orderly”. This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements. This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.
Leaving the valuation of illiquid securities to managerial discretion will lead to systematic and systemic overvaluation. Banks with significant amounts of toxic assets and plain bad assets on their balance sheet have lied, lie and continue to lie about what they have on their balance sheets. This has now been made easier. No wonder bank stocks rose and bank credit default swap rates declined. Reported asset values will be boosted. Analysts estimate that, now that banks can mark toxic assets using their own models (which are private information) rather than what they would fetch on the open market, quarterly profits at some banks could be boosted by up to 20 per cent. There was a similar response of banks’ stock valuations and CDS rates last year when the FASB last allowed banks more scope to increase the opaqueness and lack of transparency of their accounts. This was when it allowed banks to reclassify securities held on its balance sheet between the three categories “held to maturity”, “available for sale” and “trading”. Basically, “held to maturity” securities can be valued in any way the management sees fit. Securities “available for sale” and “held for trading” are, generally, marked-to-market. Unrealised gains and losses are, however, only passed into the income (P&L) accounts in the case of securities held for trading.
The IASB (International Accounting Standards Board) promptly followed the lead of the FASB when the FASB permitted the re-classification of securities between the three categories. Banks throughout the US and Europe immediately shifted securities out of the “held for trading” category and into the “available for sale” and “held to maturity” categories. It was a major exercise in shareholder deception and deception of the wider public. I expect the IASB to stand to attention and salute once more now that the FASB has run up the further-emasculation-of-fair-value-accounting-flag. The official excuse for this egregious pandering to the interests of zombie bank managers and unsecured creditors is that mark-to-market (or fair value) accounting is to blame for exacerbating banks’ capital problems and causes exacerbation of pro-cyclical and potentially systemically destabilising detrimental feedback loops between lack of market liquidity, distress asset sales, mark-to-market, margin calls, falling asset prices and lack of funding liquidity.
That argument makes no sense. It is clearly desirable that regulators and supervisors exercise regulator/supervisory forbearance as regards the implications of mark-to-market for regulatory capital requirements and for any other regulatory requirements when asset markets are distressed and illiquid. They should do the same when asset markets are perfectly liquid but subject to speculative bubbles. But given micro-prudential regulatory forbearance as regards mark-to-maket capital losses incurred on illiquid securities, and given sensible macro-prudential responses by regulators, monetary and fiscal authorities when securities markets are illiquid, there is no earthly reason for deliberately lowering the informational content and quality of published corporate accounts. This impairment of the informational content of the corporate accounts will be the inevitable consequence of replacing valuation using market prices (even illiquid market prices) with the judgment of the deeply conflicted managers of these corporations. Investors will be worse off. Corporate governance will suffer. Accountability of corporate executives and boards will diminish. And, because mark-to-myth is likely to prevent necessary corrective measures from being taken, or at least to delay them, the FASB’s encouragement of marking-to-myth is likely to increase future financial instability.
It really is wonderful how the US political and regulatory establishment is riding out in support of its wonky banks. First, the Treasury Secretary Timothy Geithner proposes a toxic and bad assets purchase scheme (the PPIP or Public-Private Investment Program) which subsidizes the private parties in the public-private partnerships bidding for the toxic assets by leveraging the private and public equity involved in the bids through non-recourse loans or guarantees. This permits - indeed encourages - private bidders for toxic assets to make bids far in excess of their estimates of the fair value of these assets. Their rents can then be split between the private bidders for the assets and the banks selling them. Second, in case even this isn’t good enough, banks that would rather not sell these toxic or bad assets, even at these inflated prices, can avoid pressure (from the regulators or from shareholders) to sell by marking-to-model (that is, marking-to myth) the assets rather than marking to market. This gives the management of the bank more time to ‘gamble for resurrection’ at the expense of the shareholders and other stakeholders, including the tax payers. Most importantly, banks with large amounts of undeclared crud on their balance sheets will act like zombie banks, engaging in little new lending or new investment in the real economy. While their managers sit, wait and pray for a miracle, intermediation between households and non-financial enterprises continues to suffer.
The G20 have made many pious statements about the need to recognise the losses that have been incurred, on and off the balance sheets of banks and shadow banks, and to ensure that the dead hand of the overhang of past losses does not act as a tax on and deterrent to new lending and borrowing by banks. Yet the primus inter pares in the G20, the USA, decides to give its banks another large fig leaf behind which to hide their losses and gamble for resurrection. This continues and prolongs the zombification of most Wall Street banks. The FASB, like the rest of the American regulatory and standards-setting establishment, appears to have been captured lock stock and barrel by the vested interests of the large Wall Street zombie banks (management, shareholders and unsecured creditors). This may well have been another example of cognitive regulatory capture, like that which has afflicted the SEC and the Fed. No doubt the IASB will wimp under also, and promulgate a new ukase permitting European banks also to substitute managerial judgment/wishful thinking for market valuation. Our accounting standard setters are making terrible and very costly choices. Paraphrasing Churchill: mark-to-market accounting is the worst accounting principle in the world, except for the others.
FHA Losses Spur Talk of a Taxpayer Bailout
Rising mortgage defaults could force the Federal Housing Administration to seek a taxpayer bailout for the first time in its 75-year history, housing officials and lawmakers said during a Senate hearing Thursday. If defaults drain the FHA's insurance fund, the Obama administration will have to decide whether to ask Congress for taxpayer money or raise the premiums it charges to borrowers. That decision will be spelled out in President Barack Obama's 2010 budget, Housing and Urban Development Secretary Shaun Donovan told lawmakers. "We are looking very closely at that issue -- at the premiums that we charge, at the losses that we have," Mr. Donovan said.
The New Deal-era agency has become the main source of financing for buyers who can't make a big down payment or who want to refinance but have little equity. Most lenders have sharply curtailed credit to those borrowers unless their loans can get backing from a government agency. The FHA's market share jumped to nearly a third of all mortgages in the fourth quarter of 2008 from about 2% in early 2006, according to Inside Mortgage Finance, a trade publication. Borrowers who make at least a 3.5% down payment can qualify for a 30-year fixed-rate loan backed by the FHA, which insures lenders against defaults on mortgages. Rising defaults are now eating through the FHA's cushion of reserves. Roughly 7.5% of FHA loans were seriously delinquent at the end of February, up from 6.2% a year earlier. The FHA's reserve fund fell to about 3% of its mortgage portfolio in the 2008 fiscal year, down from 6.4% in the previous year. By law, it must remain above 2%.
Asked at the hearing whether the FHA would need a bailout, HUD Inspector General Kenneth M. Donohue said he couldn't predict. "Based on the numbers we're seeing, I think it's going in the wrong direction," he said. The FHA often finds itself balancing two sometimes competing goals: fulfilling its mission of providing affordable loans for first-time home buyers while remaining self-funded. In an interview Wednesday, Mr. Donovan said that the agency may need to sustain losses to keep backstopping lenders who otherwise wouldn't make loans. "[W]hile we're rightly concerned about the safety and soundness of FHA...we also need to be focused on the fact that credit is critical to the economic health of the country," he said.
Thriving bear sees hundreds more bank failures
A hedge fund manager who predicted the credit crisis and tripled his investors' money over the past two years, warns that hundreds of U.S. banks are doomed to fail and that an economic recovery is far away. John Jacquemin's Mooring Financial Corp has posted 10 consecutive years of gains snapping up loans at distressed prices, while his two-year-old Intrepid Opportunities Fund generated 222 percent returns betting against corporate debt and financial stocks. Beyond a housing glut and slower consumer spending, the Virginia-based manager said he remains bearish because banks and regulators have not confronted the mountains of bad loans still on banks' books. While banks need to mark down bonds to prevailing market prices, "with whole loans, they don't have to and they haven't," Jacquemin said. "If they did, there would be literally hundreds and hundreds of insolvent banks."
Eighteen years ago, Jacquemin was a commercial lender who snapped up loans sold by the Resolution Trust Co and the FDIC in the wake of the savings & loan crisis. Jacquemin said government agencies were aggressive in closing failed banks, selling branches and deposits to the highest bidders. Today, he contends, officials have been more tentative, allowing weak banks to hobble along. "If the banks sold these loans for what they could get, they would be insolvent," Jacquemin said. "The difference between now and the '90s is the government today is not closing banks down." This approach, he said, will only prolong the crisis. "They're not being aggressive because it would scare the hell out of us," he said. "But we can't get rid of the problem the way they're approaching it now ... They ought to be closing the weak banks and helping recapitalize the stronger ones."
Though little known, Mooring has generated returns on par with renowned credit market bear John Paulson and his Paulson & Co. Jacquemin's Mooring Capital Fund has never had a losing year and returned 12 percent a year, on average, for a decade buying distressed loans and debt. The excesses of the credit bubble -- reckless leverage and frothy real estate markets -- prompted him to launch Intrepid Opportunities in February 2007. The fund shorted indexes that tracked bond and mortgage markets, as well as bet against banks, credit card lenders and other financial companies. The new fund soared 56 percent last year, when equities fell 40 percent and the average hedge fund dropped 18 percent. Jacquemin said the firm, which manages $400 million, is seeking new investors.
While bank shares have rallied in recent weeks, Jacquemin has maintained his negative views on corporate bonds and financial stocks. Jacquemin predicts rising commercial real estate defaults and worries that consumer spending will never rebound to pre-crisis levels. Housing prices, he said. will not improve until the glut of empty units is absorbed -- a process will take at least 18 months and as long as two-and-a-half years. The Treasury Department's public-private investment partnership program may clear out inventories of bonds, he said, but it does not fully resolve the piles of loans that face steep losses when finally exposed to market pricing. "The regulators are looking at the banks, and then they look away," he said. "It is so ugly that they are not prepared to deal with it because it would lead to the failure of hundreds and hundreds of banks.
Bank Regulators Brace for Fallout from Stress Tests
United States regulators have reached the closing phase of “stress tests” to gauge the health of the nation’s top banks, and are bracing for a battle to get those firms to accept tough appraisals. Officials realize it may be hard to keep the assessments under wraps, and they are looking for ways the banks could disclose some details without causing havoc in the markets, Reuters said, citing regulatory sources. If a bank needs more capital, any disclosures would likely come in concert with a recovery plan that could include government aid and private assistance. “There will be definitely be some information that will be provided at the end of it, but exactly what that will be, and when it will be provided, will come forth later,” Comptroller of the Currency John Dugan, who supervises some of the nation’s largest banks, told Reuters on Tuesday on the sidelines of a bank conference. The stress tests at the nation’s 19 biggest banks are part of a wide-ranging effort to restore stability to a sector wracked by huge mortgage-related losses. Another key plank is a public-private program to buy toxic assets from banks, which aims to clear the way for them to attract private capital.
Bank share prices, which dropped 50 percent last year, have fallen a further 35 percent so far this year. Investors have worried that mounting losses could lead the government to take firmer control of some institutions, if not to nationalize them outright. Shares at Citigroup and Bank of America, two recipients of government bailout packages, have been particularly hard hit. “I think these banks are going to be staring at some big shortfalls. If there had been a way to paper over this, the government would have done that by now,” Dean Baker, co-director of the Center for Economic and Policy Research, told Reuters. The regulatory stress tests announced by the U.S. Treasury on February 10 aim to determine how much capital the largest banks might need should the economy’s performance turn out to be much weaker than expected.
When the tests are completed at the end of April, banks found to be undercapitalized will be pushed to raise money from private sources or turn to the Treasury, which will be able to pump in capital from its $700 billion financial rescue fund. The Treasury has said it has about $135 billion in its rescue fund that has not yet been committed. But some analysts question whether that will be enough, and the Obama administration could face the unpleasant task of asking a bailout-weary Congress for more funds. The administration hopes to avoid heavy intervention — and a big financial outlay — by attracting private capital to the banks, and it expects the stress tests and the toxic asset plan to work in tandem. The Treasury aims to have the toxic asset program up and running within two months, and a need to raise fresh capital could lead some banks to unload assets at prices they deem too low in order to present a cleaner balance sheet to investors.
Regulators, however, are prepared to use pressure to get other banks to accept discounted prices for their assets. They could demand banks raise more capital, set aside more money for loss provisioning, or seek merger partners. U.S. officials have also said it behooves banks to clean up their balance sheets now so they can attract private money instead of government funds that can come with unwanted conditions. The administration’s removal of General Motors‘ Chief Executive Rick Wagoner served as a chilling example. In the meantime, bank examiners are struggling in the stress tests to get banks to accept that they are valuing assets on their books too highly, Reuters reported, citing bank industry sources. Many of the banks have completed their own stress tests, and regulators will soon sit down with the banks’ management to reconcile the differing results, the news service said.
Bank sources told Reuters that while their dealings with regulators have been cordial, they are concerned that searing government reports will damage their reputation and chances of recovery. Bankers also fret about the government’s time horizon for the firms’ health. Most of the short-term woes faced by banks can be resolved by the end of the crisis, according to Reuters. “Strictly speaking, many banks are insolvent now. In the long run, though, we can pass any test, so how much time do we have?” a banking source familiar with his firm’s stress test work told the news service.
Synthetic CDOs Becoming ‘Unmanageable,’ Fitch Says
Managers of collateralized debt obligations are struggling to prevent losses in the funds because the cost of trading the underlying contracts has soared, according to a report by Fitch Ratings. Some CDOs that package credit-default swaps are now “virtually unmanageable” because prices for the contracts have risen so high, Fitch said in a summary of the report today. The costs are preventing managers, who select contracts included in the so-called synthetic CDOs, from trading out of companies that may fail in order to preserve the funds’ loss cushions, known as subordination. “Corporate synthetic CDO managers have refrained from executing trades that would reduce the amount of available subordination for a given rating,” or would breach other requirements that can trigger downgrades, London-based Fitch analysts Manuel Arrive and Lars Jebjerg wrote in the report.
The situation has left many funds “largely static,” the analysts wrote, making them vulnerable to defaults by the underlying companies, the analysts said. Even in cases where managers hedged against losses by buying credit-default swaps on potentially failing companies, monetizing gains has become more difficult because of a widening gap between the prices dealers are willing to buy and sell protection. Last years’ seizure in credit markets prompted banks to start closing down or scaling back units that bought and sold CDOs, Fitch said. That’s increased the spread between bid and offer prices for credit-default swaps that banks left in the market can demand. “Those desks that remain in the correlation trading business have seen their allocated capital and risk appetite dramatically reduced, resulting in larger bid/ask spreads,” Arrive and Jebjerg wrote. The lack of market “liquidity” has become “a major hindrance” for managers of CDOs, they wrote.
The spread between bids and offers on credit swaps protecting against a default by General Electric Co.’s finance arm for five years has widened 22 basis points the past year to 27 basis points, according to prices from London-based CMA DataVision. The price at which dealers are willing to sell protection has soared to 747 basis points from 131 basis points during that period, CMA data show. General Electric Capital Corp., the finance unit, is the company most often included in synthetic CDOs rated by Fitch, according to data provided by the ratings firm last month. Five- year credit swaps typically are the most actively traded maturity in the market.
The cost of credit-default swaps on the benchmark Markit iTraxx Europe index of investment-grade bonds has risen to almost 180 basis points from about 20 in 2007, according to data compiled by Bloomberg. That means it costs 180,000 euros ($238,000) a year to protect 10 million euros of debt from default for five years compared with 20,000 euros before the credit crisis. Credit-default swaps are used to speculate on corporate creditworthiness or to hedge against losses. An increase indicates a deterioration in investor confidence. CDOs pool bonds, loans or credit-default swaps, channeling their income to investors in layers of differing risk.
The G20 moves the world a step closer to a global currency
The world is a step closer to a global currency, backed by a global central bank, running monetary policy for all humanity. A single clause in Point 19 of the communiqué issued by the G20 leaders amounts to revolution in the global financial order. "We have agreed to support a general SDR allocation which will inject $250bn (£170bn) into the world economy and increase global liquidity," it said. SDRs are Special Drawing Rights, a synthetic paper currency issued by the International Monetary Fund that has lain dormant for half a century. In effect, the G20 leaders have activated the IMF's power to create money and begin global "quantitative easing". In doing so, they are putting a de facto world currency into play. It is outside the control of any sovereign body. Conspiracy theorists will love it.
It has been a good summit for the IMF. Its fighting fund for crises is to be tripled overnight to $750bn. This is real money. Dominique Strauss-Kahn, the managing director, said in February that the world was "already in Depression" and risked a slide into social disorder and military conflict unless political leaders resorted to massive stimulus. He has not won everything he wanted. The spending plan was fudged. While Gordon Brown talked of $5 trillion in global stimulus by 2010, this is mostly made up of packages already under way. But Mr Strauss-Kahn at least has resources fit for his own task. He will need them. The IMF is already bailing out Pakistan, Iceland, Latvia, Hungary, Ukraine, Belarus, Serbia, Bosnia and Romania. This week Mexico became the first G20 state to ask for help. It has secured a precautionary credit line of $47bn. Gordon Brown said it took 15 years for the world to grasp the nettle after Great Crash in 1929. "This time I think people will agree that it has been different," he said.
President Barack Obama was less dramatic. "I think we did OK," he said. Bretton Woods in 1944 was a simpler affair. "Just Roosevelt and Churchill sitting in a room with a brandy, that's an easy negotiation, but that's not the world we live in." There will be $250bn in trade finance to kick-start shipping after lenders cut back on Letters of Credit after September's heart attack in the banking system. Global trade volumes fell at annual rate of 41pc from November to January, according to Holland's CPB institute – the steepest peacetime fall on record. Euphoria swept emerging markets yesterday as the first reports of the IMF boost circulated. Investors now know that countries like Mexico can arrange a credit facility able to cope with major shocks – and do so on supportive terms, rather than the hair-shirt deflation policies of the old IMF. Fear is receding again. The Russians had hoped their idea to develop SDRs as a full reserve currency to challenge the dollar would make its way on to the agenda, but at least they got a foot in the door.
There is now a world currency in waiting. In time, SDRs are likely evolve into a parking place for the foreign holdings of central banks, led by the People's Bank of China. Beijing's moves this week to offer $95bn in yuan currency swaps to developing economies show how fast China aims to break dollar dependence. French President Nicolas Sarkozy said the summit had achieved more than he ever thought possible, and praised Gordon Brown for pursuing the collective interest as host rather than defending "Anglo-Saxon" interests. This has a double-edged ring, for it suggests that Mr Brown may have traded pockets of the British financial industry to satisfy Franco-German demands. The creation of a Financial Stability Board looks like the first step towards a global financial regulator. The devil is in the details. Hedge funds deemed "systemically important" will come under draconian restraints. How this is enforced will determine whether Mayfair's hedge-fund industry – 80pc of all European funds are there – will continue to flourish.
It seems that hedge funds have been designated for ritual sacrifice, even though they played no more than a cameo role in the genesis of this crisis. It was not they who took on extreme debt leverage: it was the banks – up to 30 times in the US and nearer 60 times for some in Europe that used off-books "conduits" to increase their bets. The market process itself is sorting this out in any case – brutally – forcing banks to wind down their leverage. The problem right now is that this is happening too fast. But to the extent that this G20 accord makes it impossible for the "shadow banking" to resurrect itself in the next inevitable cycle of risk appetite, it may prevent another disaster of this kind. The key phrase is "new rules aimed at avoiding excessive leverage and forcing banks to put more money aside during good times." This is more or less what the authorities agreed after the Depression. Complacency chipped away at the rules as the decades passed. It is the human condition, and we can't change that.
The Stock Market's Happy Daze
Stocks have soared on some tidbits of good economic news and G-20 optimism. Wait till earnings season rolls around. A 25% rally in U.S. stocks in just three weeks has lightened the mood on Wall Street. But professional investors also are scratching their heads, wondering how market sentiment could have shifted so quickly. In early March, there was much doom and gloom, and major indexes sat at their lowest levels in a dozen years. "The tone has definitely changed over the last three or four weeks," says Robert Bacarella, portfolio manager of the Monetta Mutual Funds. Stocks have been lifted by various news items, chiefly a U.S. Treasury plan to buy up toxic assets and the occasional, small signs the economy might be slowing its slide. On Apr. 2, stocks extended their gainson two news items: At the G-20 economic summit world leaders tripled lending by the International Monetary Fund to emerging countries. And, in Washington, the Financial Accounting Standards Board, or FASB, relaxed rules on marking down assets, which should limit losses reported by banks and other institutions.
But all this news hasn't altered a fundamental fact: The economy, both in the U.S. and worldwide, is in bad shape, and a strong recovery is hardly guaranteed. "The sum of all these small bits of news doesn't add up to the whole of a good fundamental outlook," says Chris Johnson of the Johnson Research Group. Stocks may have seen their worst levels in early March, but that doesn't mean the economy has hit bottom. "There's nothing out there yet that would really suggest we're close to a bottom in the economy," says John Merrill, chief investment officer at Tanglewood Wealth Management. That doesn't mean the shift in investors' mood isn't significant. A public relations campaign by the Obama Administration and others has been largely successful in lifting market confidence, says Johnson, who initially doubted this rally. "The path of least resistance right now, whether right or wrong, is to the upside," he says. Rob Lutts, founder and president of Cabot Money Management, worries about the long-term effects of loosening accounting rules. But for the short term, the FASB decision "gives [banks] a little extra cushion, which they needed."
And, many investors bet that what is good for the banks is good for the economy. "What the economy needs to recover is easier credit," says Uri Landesman of ING Investment Management (ING). He hopes the FASB rule change stimulates more bank lending. More resources for the International Monetary Fund are a positive for investors looking for a revival in the world economy. Tanglewood's Merrill is investing in emerging markets and especially China. Those markets "got beat up the most last year," he says, but "their long-term attributes seem to be at least as good, if not better, than developed markets." "It's all coming together," Bacarella says of the recent tidbits of good news. But, he warns: "The little pieces are constructive, but we still need that key confirmation." That would be real signs that the economy has stabilized. An important test for the market and economic fundamentals will be the first quarter earnings season. On Apr. 7, Alcoa (AA) will be the first major company to report results from the first three months of 2009. Earnings season "is where we're going to see the proverbial rubber meeting the road," Johnson says.
Earnings are expected to be brutal, which makes sense for a quarter in which Action Economics estimates the U.S. economy shrunk 4.5%. Yet investors' expectations are already very low, and they will listen for any traces of a hopeful tone in the outlooks given by executives, Johnson says. In earnings stabilize or if executives' outlooks improve, stocks could make a further move higher, Johnson says. But the recent market rally might be a problem for investors hoping for a positive reaction to earnings news. A month ago, with stocks looking very cheap, a few pieces of good news were enough to spark a rally. Brian Reynolds, chief market strategist at WJB Group, explains that, when stocks are in an "oversold condition, any good news is taken positively." By contrast, "now, it's a battleground," he says, between bearish and bullish investors. "The market's a little overbought," Landesman says. "It's tolerance for bad news is not that high."
And bad news is certainly in the offing. Even if the U.S. economy recovers in the second half of the year, nearly every economist expects unemployment to go higher. "The economy is bad and likely to get worse," Reynolds says. Instead of a rebound, he predicts the economy could falter again in the second half of the year, followed by a recovery finally in 2010. By contrast, if you believe the economy can bounce back soon, you're optimistic for stocks. "The market can move up from here, especially when the economy shows some signs of bottoming," Landesman says. Reynolds says markets, driven by short-term traders, could see some violent moves in the weeks ahead—either up or down. Johnson agrees, saying, "this market could turn very, very quickly." The stock market seems to reflect the perception that the worst is over, Bacarella says. "But we still don't have a lot of conviction that things are going to get better soon," he adds. In that environment, investors are naturally jittery. They're stuck waiting for a recovery—in earnings and the economy—that might not arrive for quarters or even years. So while the current market rebound may prompt some guarded cork-popping, don't look for a full-scale celebration on Wall Street anytime soon.
Failure Rate Rises on US Mortgages Revised in Late 2008
Mortgages modified in the third quarter failed at a faster pace than those revised in the first, and the delinquency rate on the least risky loans doubled, signs of deteriorating credit quality, U.S. regulators said. Loans modified in the first quarter to help borrowers keep their homes fell delinquent 41 percent of the time after eight months, and second-quarter loans had a 46 percent default rate, the Office of the Comptroller of the Currency and Office of Thrift Supervision said in a report today. Third-quarter trends “are worsening,” the agencies said. “For the year and this quarter, we saw the same trend that we saw last time: quite high re-default rates, no matter how we measured them,” John Dugan, the U.S. Comptroller of the Currency, said in a conference call with reporters.
Lenders including Citigroup Inc. and loan-servicing companies are adjusting mortgages by lowering interest rates or crafting longer-term payment plans. The Obama administration is acting to help as many as 9 million struggling homeowners by using taxpayer funds to pay lenders such as bond investors, mortgage servicers for reworking the mortgages. Dugan said higher re-default rates are likely related to stressful economic conditions and new loan plans are not producing significant reductions to make mortgages sustainable. “Credit quality continues to decline and that’s true of all types of mortgages that we cover by risk category,” Dugan said. Prime mortgages that were delinquent after 60 days more than doubled in the fourth quarter, to 2.4 percent from 1.1 percent in the first, and rose significantly from the third quarter to the fourth, the report showed. Prime mortgages, considered the least likely to fail, account for two-thirds of all mortgages.
Borrowers with mortgages that were modified in the first quarter re-defaulted after three months 22 percent of the time, while loans revised in the second quarter had a 27 percent failure rate and third-quarter loans that were 60-days overdue failed 31 percent of the time, the report showed. Seriously delinquent mortgages, those 60 days or more overdue, increased in all loan categories in the fourth quarter, including subprime, Alt-A, and prime loans. The percentage of borrowers skipping the first payment on a modified loan rose significantly in all categories, except prime loans, the agencies said. Fourth-quarter first-payment defaults on subprime mortgages rose to 4.4 percent from 3.8 percent in the first, and overall climbed to 1.4 percent from 1.2 percent in the first, the report showed.
5 US banks repay $353M in bailout funds
Five banks have repaid millions of dollars they received from the government's $700 billion financial bailout pot, the Obama administration said Thursday. The Treasury Department, which oversees the bailout program, said the banks returned a total of $353 million. The banks are: Iberiabank Corp. of Lafayette, La.; Bank of Marin Bancorp of Novato, Calif.; Old National Bancorp. of Evansville, Ind.; Signature Bank of New York; and Centra Financial Holdings Inc. of Morgantown, W.Va. They were the first banks to repay the government, wanting to escape the increasingly tough restrictions placed on participants in the rescue program. In addition to the $353 million, the banks paid the government a total of $5.4 million in dividends, Treasury Department spokesman Andrew Williams said. The program was enacted in early October after the financial crisis -- the worst since the 1930s -- intensified. The goal of the program was to inject capital in banks so that they would be in a better position to boost lending, a crucial ingredient to any economic recovery. Nearly $200 billion has been injected into banks thus far. The five banks have 15 days to buy back warrants from the government. If they don't, the government will sell them to private investors, Williams said.
ECB Faces Day of Reckoning on New Policy Measures
The European Central Bank is facing a day of reckoning in its response to Europe’s worst recession since World War II. After months of delay and internal debate, President Jean- Claude Trichet said yesterday the ECB will announce its decision on new policy tools next month as interest rates edge toward zero. The danger is that the economy will slip further into recession the longer the bank delays. “By again buying time, the ECB risks falling further behind the curve,” said Carsten Brzeski, an economist at ING Groep in Brussels. “You cannot buy time forever.”
The debate on the Governing Council pivots on whether the ECB should follow the Federal Reserve and the Bank of England in buying debt securities to rescue the economy. Germany’s Axel Weber argues that the ECB must avoid cutting rates to zero and can’t take too much risk onto its balance sheet. Vice President Lucas Papademos counters that such a move could free up credit markets. The result may be a compromise that’s already taking shape. The ECB yesterday cut its benchmark rate by less than economists had forecast, reducing it by a quarter point to 1.25 percent, and Trichet said the deposit rate has reached a floor at 0.25 percent. At the same time, he indicated the ECB may still reduce the benchmark again and said it’s looking at “optimizing what could be done and should be done to enhance credit support.”
“The council has still not yet made up its mind on what new non-standard measures it would take,” said Julian Callow, chief European economist at Barclays Capital in London. James Nixon, an economist at Societe Generale SA and a former ECB forecaster, said the announcements had the hallmark of an “uneasy compromise between differing views.” The euro rose 1.6 percent against the dollar yesterday, climbing as high as $1.3517. It slipped 0.3 percent to $1.3428 today. As the ECB ponders its next move, other central banks and governments are ramping up their response to the global recession. Leaders from the Group of 20 nations yesterday pledged more than $1 trillion in emergency aid to cushion the economic fallout. Policy makers in the U.S., the U.K. and Japan have already cut rates to close to zero.
Europe’s economy is also deteriorating and may shrink as much as 4.1 percent this year, according to the Organization for Economic Cooperation and Development. Unemployment jumped to a three-year high of 8.5 percent in February. European finance ministers may press Trichet for details on his intentions today when they meet in Prague for a regular summit. Possible options for the ECB include buying commercial paper and corporate debt, widening the pool of collateral accepted in market operations and offering banks loans over a longer term, said Elga Bartsch, an economist at Morgan Stanley in London. Purchases of government debt are less likely, she said. The ECB is hemmed in by European Union rules that forbid it from buying bonds directly from governments, and any decision to buy such debt in the open market may spark political disputes.
Some economists defended Trichet’s refusal to announce non- standard measures yesterday. Stephane Deo of UBS AG said “technical issues are not to be underestimated” as the ECB grapples with a founding treaty that deprives it of a European treasury to indemnify it against losses. Finance ministers today signaled they were satisfied with yesterday’s rate cut. Portugal’s Fernando Teixeira dos Santos told reporters in Prague the ECB is “making an effort” and Austria’s Josef Proell said the reduction may be “enough.” Trichet will attend a press briefing chaired by Luxembourg Finance Minister Jean-Claude Juncker, who heads the body of euro region finance ministers, at 11 a.m. in Prague today.
The ECB may also surprise economists and investors who have criticized it for not going as far as the Fed and the Bank of England, said Marco Annunziata of UniCredit Group. While the ECB “disappointed markets” yesterday, “the stage was set for a possible ‘big bang’ next month,” he said. That could include doubling the maturity of bank loans to 12 months and purchases of corporate debt. “This could have a major market impact, lowering yields significantly and allaying concerns of a very prolonged slump in euro-zone activity,” Annunziata said. “The dire growth outlook clearly calls for further action.”
Zombie curse of Europe’s CLOs
by Gillian Tett
A decade ago, when I worked as a reporter in Tokyo, I worried about Asian zombies. For when the Japanese banks tipped into crisis in the late 1990s, scores of companies were cast into an “undead” state – in the sense of being too weak to flourish, but too complex and costly for their lenders to shut down. Hence they remained half-alive, poisoning the corporate world by silently spreading a sense of stagnation and fear. Now it seems that the zombie curse is theatening to appear in Europe too. In recent months, investors and policy makers alike have devoted huge attention to tackling the problem of toxic mortgage debt. But so far, they have generally ignored the corporate debt world. On one level that is unsurprising: to date, the losses on corporate debt have been insignificant compared to the mortgage sphere. However, that eerie calm does not mean all is well. Far from it. Deep inside the corporate debt markets the climate is turning increasingly sour. And if this continues unchecked it will have poisonous implications for the wider economy – not least due to the terrible “zombie” curse.
The key issue revolves around Europe’s vast, collateralised loan obligation market. A decade ago, when companies took out loans that were ranked below investment grade (“leveraged loans”), more than 90 per cent of that debt stayed in the hands of banks. But earlier this decade, asset managers started to create CLOs (or vehicles that invest in bundles of bank loans). By 2007 there were more than 50 such CLO managers in London, who were buying over half of all leveraged loans. Indeed, their appetite for corporate loans was so voracious that borrowing costs became absurdly cheap for buyout funds - which in turn fuelled a LBO boom. Now, however, many of the LBOs arranged from 2005 onwards are quietly going wrong. No wonder. After all, Europe’s economy is contracting and some of the LBOs arranged in 2006 and 2007 carry absurdly high debt burdens, sometimes eight times projected earnings.
In a rational world, many of those over-levered, underperforming companies should now go bust, wiping out the equity and junior debt holders (at least). Some of those entities might sensibly then be restructured; others, though, die. There is a limit, for example, to how many yellow page operators or estate agents an economy needs. But in reality that shakeout is barely happening. Instead, a host of over-leveraged entities are staggering on, in a half-dead state, Just take a look at Foxtons, the British estate agent (in breach of covenants but still in business), or Klöckner Pentaplast, the German plastic film maker, (engulfed in debt, but still operating.) In part, this situation reflects a dire shortage of funds to support restructuring. In the current, liquidity-starved climate, there are few hedge funds able to support a work out. Instead, the only groups that can support a restructuring tend to be the private equity groups themselves. But that means when companies run into problems, the equity holders are generally not being wiped out; instead, these LBO groups tend to keep sticking money into the company to keep them staggering on. The other big problem lies with the CLOs.
As my colleagues Paul Davies and Anousha Sakoui have recently written, precious few CLO management groups in London currently have the skills - or funds - to oversee restructuring deals. Nor do they always have much incentive to push for rational workouts. After all, these managers only receive fees if they can keep their CLOs alive; if triggers are breached in a manner that forces an unwind (say, if the value of loans collapses, or loan ratings fall) the fee income dries up. Hence many CLO managers - like many private equity groups - have incentive to keep propping the system up, as long as they can. They also have incentives to protect the junior tranches of CLO debt, since that produces most fees. No wonder that Mayfair is buzzing with rumours that a few small CLO managers are using unorthodox approaches for valuing their loans, or acting in a partisan manner in relation to the interests of junior debt.
I have no idea whether such rumours are true (and unless you are a CLO investor it is almost impossible to check, and pretty hard even if you are.) But what is crystal clear is that the problem will not die away soon. After all, the pressure on the CLOs and corporate world alike is mounting, as Europe’s economy worsens. Yet, as long as the incentive structure remains this perverse, the players have motives to keep propping things up. It all feels – dare I say it – terribly Japanese. And while that might not worry policy makers right now, since no politician ever wants to hasten corporate bankrupctcies, the implications are alarming. Just look at Japan for evidence of that. For a world litttered with corporate zombies is a not a world where activity is likely to flourish again soon - particularly when those half-dead companies are linked to their new 21st century bastard brethren, the zombie, half-dead CLO.
China Urges World Monetary System Diversification
China on Thursday kept up its call for diversification of the international monetary system and for advancement of Doha round of trade talks, reflecting its vulnerability to the global trade contraction and to the U.S.'s expansionary policies. Chinese President Hu Jintao urged leaders from the Group of 20 nations to "improve the mechanisms for controlling the issuance of reserve currencies," and urged the International Monetary Fund to step up its supervision of reserve-currency nations, especially their currency-issuance policies. China, the biggest creditor nation to the U.S., worries that the U.S.'s economic recovery efforts through widening its fiscal deficit and pumping liquidity into financial markets could fuel U.S. inflation eventually. That would erode Beijing's dollar assets and add to Chinese inflationary pressures.
The G20's support for "even-handed" surveillance by the IMF reflects in part Beijing's call for greater monitoring of major economies. One criticism of the IMF is that it has focused on developing nations, not rich nations, such as the U.S., where the crisis started. But the G20 statement issued after the summit doesn't talk about diversifying the international monetary system and diminishing the U.S. dollar's dominant role in trade and investments, despite such calls from China and Russia. Asked about People's Bank of China Governor Zhou Xiaochuan's call last week for creating over time a new global reserve currency, U.K. Prime Minister Gordon Brown said at a press briefing Thursday that it "hasn't led to detailed proposals from anyone."
On recapitalizing the IMF, Hu said Beijing "supports fund increases for the IMF, and is willing to explore [it] with various sides and to make its rightful contribution." Financial increases for the IMF should be in line with a balance of responsibilities and rights, Hu said. Hu's remarks, published on the state-run Xinhua News Agency's Web site, didn't specify how large a contribution Beijing would make to the IMF. At his press briefing, Brown had said Thursday that China will contribute $40 billion to the IMF but didn't say if Beijing will do so through purchase of IMF bonds or other loan arrangements. As well, Beijing is worried that nations are putting up trade barriers and hurting Chinese exporters and workers just as global demand is slumping. For instance, India this year banned Chinese toy imports for six months.
China will offer $1.5 billion to support the trade financing efforts of the International Finance Corp. China's Commerce Minister Chen Deming on Thursday urged major nations to demonstrate flexibility as soon as possible on the Doha round of talks, and vowed that Beijing won't resort to protectionism despite the ongoing crisis. Speaking at a press briefing after the summit ended, he urged nations to resume the Doha round on the basis of the consensus formed in previous negotiations, rather than restart the talks all over again. "We need to give some nations, particularly those big nations that have just had change of leadership, some time" to review their stance, said Chen. "We hope they will carry out their review as soon as possible, because time is important to us."
On the domestic economy, Hu said China has "big scope to adjust macroeconomic policy," echoing Premier Wen Jiabao's remarks in March the government is prepared to do more to bolster the economy if that is needed. Hu reiterated that the Chinese economy has started to show signs of improvement. Hu said China has maintained the basic stability of the yuan exchange rate, and urged the G20 to maintain "relative stability" of exchange rates among major currencies, a view Finance Minister Xie Xuren had flagged last week.
Credibility is key to policy success
by Martin Wolf
The UK has followed the US and Japan into “unconventional monetary policy”. Meanwhile, Mervyn King, governor of the Bank of England warns the UK government of the dangers of further discretionary fiscal stimulus. Yet what are the implications of the policies followed by central banks? Are these not the big threat to monetary stability? According to forecasts from the International Monetary Fund, the UK’s general government deficit will be 9.5 per cent of gross domestic product this year and 11 per cent in 2010, the largest in the Group of 20. As I argued earlier this week (“Why G20 leaders will fail to deal with the big challenge”), the rise in the deficit, from 2.7 per cent of GDP in 2007, is the counterpart of the swing in the private balance, forecast at 8.9 per cent of GDP between 2007 and 2009. As my colleague, Samuel Brittan, asked last week, why should such a temporary increase in the fiscal deficit be terrifying? UK net public debt – forecast at 61 per cent of GDP this year – remains well below the average of advanced country members of the G20.
At the end of the Napoleonic and second world wars, UK public debt was close to 2.7 times GDP. Yet even this triggered none of the hyperinflationary consequences now widely feared. As the IMF also notes, even a 100 percentage point increase in the debt ratio should require an offsetting shift in the primary fiscal balance (with interest payments removed from spending) of no more than 1 per cent of GDP, provided fiscal credibility is maintained. The condition for this is evident: in his Budget, the chancellor of the exchequer should lay out fiscal measures to go into effect, automatically, once the economy recovers. In short, what is needed is a far more credible fiscal regime. Yet it is very peculiar to be agitated about the inflationary impact of fiscal deficits, yet relaxed about monetary expansion by central banks. Is the latter not the true danger? Or are these not just two sides of one coin, the ultimate inflationary risk being the central bank financing of deficits?
Yet, even before reaching that point, reliance on aggressive expansion of the balance sheet of the central bank has dangers, including for the fiscal position, as my colleague Willem Buiter has noted in his Maverecon column. Unconventional monetary policies work by expanding the money supply (“quantitative easing”), by easing credit constraints (“credit easing”) and by altering relative yields on assets, particularly through direct purchases of longer-term assets. The Bank of Japan focused on the first; the Federal Reserve has concentrated on the second; and the Bank of England has now initiated the last, with direct purchases of gilts. Carried out with sufficient single-mindedness, such programmes will “work”. At the limit, a modern central bank can drown an economy in infinite quantities of fiat (or man-made) money. The question is the obverse: it is whether the longer-term inflationary impact of monetary expansion can be reversed in time. To this, again, two answers exist: one concerns feasibility; and the other concerns credibility.
On the former, the broad answer is that a central bank’s unconventional monetary operations are reversible: if it buys bonds, it can resell them; if it buys short-dated paper, it can allow it to expire; if it directly finances government deficits, it can sell the public debt to the public; and even if it sends cheques directly to every citizen, which would be closest to a purely fiscal operation, the government can always sterilise the monetary effects by issuing new bonds. So, if and when economies and, as important, financial systems, recover, aggressive action by the authorities would unwind the inflationary impact of even these unconventional policies. So, as over fiscal policy, the fundamental question – as Spencer Dale, the Bank’s new chief economist, notes in an important recent speech – is the credibility of the commitment to stability.* If, for example, the central bank takes very large credit risk and the public doubts the willingness of the fiscal authorities to reimburse resulting losses, it will expect these losses to be monetised.
Similarly, the public may well doubt whether the huge expansion in central bank balance sheets – as is evident in the US – would be reversed in time. Inflationary expectations may then gain a firm hold, driving inflation-risk premia up and the exchange rates down. This would greatly increase the costs of restoring credibility on the inflationary upside, thereby further undermining the central banks’ ability to do so when the time comes. The conclusion is straightforward: the ability to navigate through the crisis, using either fiscal or monetary measures effectively and at modest overall cost, depends in both of these cases on the credibility of the authorities’ commitment to long-term monetary stability. Neither huge fiscal deficits nor massive monetary expansions are themselves an unmanageable threat, provided the regime itself remains credible. This is crucial even for a country as indispensable to the global economy as the US. For the UK, it is close to a matter of economic life and death.
A Fraud Probe Startles Austria
Julius Meinl V, chairman of an Austrian bank that bears his family's name, was arrested in a potential €3 billion ($4 billion) fraud case involving a real-estate fund created by the bank. Wednesday night's arrest of Mr. Meinl and the investigation in a related case of former Austrian finance minister Karl-Heinz Grasser has caused a stir in Austria. Mr. Meinl is an heir to a coffee-roasting and grocery empire that dates back to 1862. A Vienna street, Julius Meinl Gasse, bears the family name. Mr. Grasser was one of Austria's most popular politicians in the Austria Liberal Party or FPÖ -- frequently photographed together with his socialite wife.
Charged on Wednesday by Vienna prosecutors with embezzlement and fraud in connection with two companies, Mr. Meinl was one of about a dozen suspects named in the case, said Gerhard Jarosch, a spokesman for the prosecutor's office. At the center of the charges is Meinl European Land Ltd., a company based in the isle of Jersey and controlled by Mr. Meinl. The real-estate firm was created by Meinl Bank but publicly listed on the Vienna Stock Exchange. The probe comes as a second blow to Austria's financial institutions in recent months. In December, Austria's Bank Medici was identified as a conduit for more than $2 billion in investments in the New York-based Ponzi scheme run by Bernard Madoff. No charges have been filed against any Bank Medici employees. Bank Medici, its directors and senior management have said they knew nothing about the Madoff fraud at the time.
Unlike in the Madoff case, Meinl European Land did make actual investments, primarily in Eastern European real estate, the prosecution spokesman said. Mr. Jarosch said prosecutors haven't yet put a number on how much of the fund's money they allege was stolen in total. Meinl Bank said the arrest "has no effect on the business of the bank. The bank is stable and the deposits safe." Mr. Jarosch alleged that Mr. Meinl and other suspects ran an expensive advertising campaign in Austria between about 2004 and 2006 to sell certificates representing shares in Meinl European Land, but not the shares themselves, to thousands of small investors.
Among the charges against the 49-year-old Mr. Meinl is that the company overcharged clients by €300 million in commissions on sales of the certificates, Mr. Jarosch said. Mr. Jarosch declined to provide specific details of the commission calculation, but described it as very complicated. Later, the company issued shares without informing the certificate holders -- small investors who held certificates representing shares held by the fund. The shares were sold cheaply to a beneficiary and bought back at a much higher price, according to Mr. Jarosch. The 150-million-share issue was sold at one cent per share, or €1.5 million, according to Mr. Jarosch. Meinl European Land allegedly then bought shares back at €20 per share, valuing the issue at €3 billion. That left the unnamed beneficiary with a large profit, although Mr. Jarosch declined to say how many shares were bought back.
Herbert Eichenseder, a lawyer for Mr. Meinl, declined to comment or discuss details of the case. He said Mr. Meinl deposited a €100 million bail payment with the court on Thursday. Mr. Meinl was held overnight on Wednesday, and Mr. Jarosch said Mr. Meinl would be released late Thursday or Friday, but only after the court verified that the bail money can't be recalled by the bank. In August 2008, shortly after the share issue, Meinl European Land was renamed by its new management as Atrium European Real Estate Ltd., following an injection of €500 million by outside investors. Richard Sunderland, a spokesman for Atrium European Real Estate, says the current fund and its management named by the new investors aren't under investigation.
Mr. Jarosch says prosecutors also are investigating allegations that Mr. Meinl and other suspects manipulated the share price of Meinl Power Management Ltd. between 2006 and 2007, buying shares from themselves through trustees. Mr. Grasser was a director at Meinl Power Management during part of this period, and prosecutors are investigating his activity, Mr. Jarosch said. A lawyer for Mr. Grasser said his client was a secondary figure in the probe. Mr. Meinl and Mr. Grasser, 40, have known each other for years, the lawyer said. Mr. Grasser was named a director of Meinl Power Management, a subsidiary of Meinl Bank, in June 2007, shortly after he retired as finance minister, said the lawyer, Manfred Ainedter, in a telephone interview. Mr. Ainedter said prosecutors informed him about the investigation involving Mr. Grasser as long ago as September 2007. Mr. Ainedter said Mr. Grasser is innocent and wasn't involved in the alleged fraud or embezzlement.